The Indian banking sector is in the spotlight for investors, with the highest credit growth in a decade. Credit growth is expected to rise in tandem with rising corporate demand. PSU banks valuation has risen in the last two quarters. The Nifty Bank index has risen more than 20% in the last six months with Nifty PSU Bank rising 60%. The broader Nifty 50 index is also up by 11.33%.

Private banks have historically beaten PSU banks in terms of profitability, asset quality, liquidity, and credit growth. PSU banks are now catching up, but with a delayed effect.

The one underlying change affecting all major banks is the uptick in repo rates. The Reserve Bank of India (RBI) has been taking an aggressive stance since the start of FY23 to control inflation. RBI has increased the repo rate by 225 bps since the start of FY23. Repo rate changes have a profound impact on banking fundamentals.

In an ideal scenario, a higher repo rate means an increase in cash coming in (deposits, savings) and a decrease in cash outgo (advances) for the banking system. Current Accounts and Savings Accounts (CASA) deposits trend in a downward direction. Also, in such a situation, deposit growth will outpace credit growth and higher deposits will increase the cost of funding for banks. But the current state of Indian banks tells a different story. Banks are seeing credit growth exceeding deposit growth.

Credit growth exceeds deposit growth for banks

PSU Banks have seen average YoY credit growth of 18.40% in Q2FY23, outpacing the deposit growth of 9.40%. The same has been true with private banks. Private banks achieved YoY credit growth of 21% in Q2FY23, beating the more modest deposit growth of 13.90%.

The credit growth of the Indian banking industry for H1FY23 touched a decadal high of 17.4%. One of the major reasons for banks’ aggressive lending is increased liquidity in the system. Since the beginning of COVID-19, banks have been wary of lending, citing the economic slowdown. This, in turn, has led to a lower Credit Deposit ratio (CD ratio). As the economy picked up, banks increased their lending to take advantage of a lower CD base. A higher CD ratio means better utilization of deposits, and better interest margins and profitability.

State Bank of India (SBI) and Canara Bank reported YoY credit growth of 19.93% and 20% in Q2FY23 respectively. SBI’s CD ratio increased from 76.50% in Q2FY22 to 80.12% in Q2FY23. Canara Bank’s CD ratio improved from 68.34% in Q2FY22 to 76.26% in Q2FY23. 

ICICI Bank and Axis Bank reported YoY credit growth of 22.70% and 17.56% respectively. The improvement was backed by a change in CD ratios of 7.85% and 5.70% respectively. The largest private lender HDFC Bank saw a credit growth of 19% YoY.

Credit growth was also supported by the liquidation of High-Quality Liquid Assets (HQLA). Banks ideally need to maintain a Liquidity Coverage Ratio (LCR) above 100%. The overall LCR of banks dropped from 173% in Q2FY21 to 136% in Q2FY23.

Corporate lending to drive further credit growth

Corporate lending was taboo post-NPA unwinding. Banks increasingly concentrated on retail lending, which is considered much safer. Housing loans in particular, have been the go-to segment for banks for the last couple of years. Post Covid, banks relied more on auto and personal loans, which remained the major drivers for credit growth in the past four quarters.

Q1FY23 saw a change in lending patterns. Banks are back to wooing corporations for borrowings. The share of corporate lending in the overall banking portfolio has seen an uptick.

Canara Bank has seen a QoQ increase of 75 bps in its corporate lending share in Q2FY23. Bank of India saw an increase of 100 bps in the same period. SBI’s corporate loan book has grown over 21% YoY in Q1FY23 compared to its retail loan book growth of 18%. Axis Bank and IndusInd Bank reported a QoQ increase of 65 bps and 100 bps in Q2FY23 respectively.

The bigger banks are going after corporate lending to aid credit growth. Smaller banks are still cautious in their approach and playing safe by lending mainly to retail portfolios.

Pressure on margins due to lower CASA deposits offset by credit growth

Traditionally, CASA has been the cheaper source of funds for banks. This doesn’t mean higher CASA ratios are good for banks. A very high CASA ratio might lead to liquidation problems if a bank goes bust. Thus, most banks maintain the CASA ratio in the range of 30-50%.

The recent increase in interest rates has enticed customers to lock in higher interest rates by opting for term deposits. This has led to a decrease in CASA shares in bank deposits. The fall in CASA share has been more visible since the end of Q4FY22.

Bank of Baroda saw its CASA share drop from 44.24% in Q4FY22 to 37.62% in Q2FY23. SBI, on the other hand, saw its share of CASA deposits fall to 42.90% in the same period.

Private banks are fairly better due to their high interest rates on savings accounts. ICICI bank and HDFC Bank saw a drop of 211 bps and 142 bps in CASA for H1FY23 respectively. Federal Bank has been more stable with a 53 bps change in the same period.

The decrease in CASA has led to an increase in the cost of deposits for the banks. The numbers reported for Q2FY23 make it more evident.

However, the increase in the cost of deposits has been offset by the higher credit growth banks are seeing. Banks were parking their deposits with RBI instead of lending, constricting margins. With higher lending offtake, margins have remained stable for banks over the last four quarters. In turn, the margins have improved slightly in the past two quarters.

Further margin expansion is expected due to the higher linkage of loans to floating rates

The Marginal Cost of Lending Rate (MCLR) was introduced in April 2016. Earlier, banks were not transferring the benefits of the change in repo rate to customers across segments. The retail segment and MSMEs were not able to get the complete benefit of MCLR. Hence, RBI introduced the External Benchmark Lending Rate (EBLR) which is directly linked to its repo rate for the benefit of retail and MSME loans.

RBI has taken a keen interest in loan linkages to MCLR and EBLR which has resulted in more advances linked to these floating rates. SBI has linked 34% of its loan to EBLR and another 45% to MCLR. The only hiccup is that these loans reflect the changes in interest rate with a delayed effect of 3-6 months.

RBI has increased the repo rate by 225 bps since May 2022. The pass-on effect has not been evident in the banks. Banks, on average, have increased lending rates by 105-130 bps. The yield on advances is expected to rise further considering EBLR/MCLR-linked loans will start incorporating the upward repricing of interest rate changes in the past six months. Repricing of lending books will provide a higher yield on advances. The effectiveness of transmission under the EBR regime was reflected in the better-than-expected NIM trajectory in Q2FY23.

The margin expansion cycle is expected to slow down in FY24.

RBI is expected to raise its repo rate by another 50 bps in CY2023. As the deposit rates start catching up, banks can expect more money to come into the system. With higher interest rates, credit growth might slow down going forward. The current phase of NIM expansion will continue to be aided by growth in advances, albeit at a slower pace. Currently, net interest margins are at a two-year high.

This is in line with the performance as the Nifty PSU Bank has risen 44.06% in the past three months. All PSU banks outperformed the Nifty 50 index. Reports suggest that Nifty PSU is outperforming the Nifty 50 index by a considerable margin. Nifty PSU Bank has risen 60% in the past year, while Nifty 50 rose 8%.

This analysis by Trendlyne is meant for investor education - to help understand companies and make informed investment decisions on their own. It should not be considered an investment recommendation.